On Buffett, Market Timing, and Dividends

"Be fearful when others are greedy and greedy only when others are fearful."-- Warren Buffett, 2004 letter to shareholders.

The Oracle of Omaha has a great many quotes that have worked their way into our investing lexicon, but none more so than the one above.

Sadly, it's also the most misunderstood quote of Buffett's time. Below, I'll offer up some context behind Buffett's quote and give some hard evidence to add perspective.

Poor investor resultsWhen Buffett wrote his 2004 letter to shareholders, he wanted to point out that though the market had produced incredible returns over the previous 35 years, the individual investor had largely missed out on such gains. He identified three culprits: fees associated with investment management or frequent trading, making decisions based on fads instead of fundamentals, and a "start-and-stop" approach to investing that leads to poor entry points.

Buffett wraps up the paragraph by saying: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful." [Emphasis added.]

Though there's certainly truth to Buffett's assertion -- that prices are low and attractive when others are bearish and vice versa -- he never meant for it to become the mantra of the individual investor.

His statement is more akin to a health guru stating, "You shouldn't drink soda at all, but if you insist, stick to diet soda." There's no doubt those who abstain from the beverages are -- all things being equal --- better off, but legions of diet drinkers are given solace from the statement.

Want proof?Luckily for us, there's a way to back-test how effective Buffett's strategy would have been in the past. Starting in 1987, the American Association of Individual Investors has taken a sentiment survey on how investors think the market will fare over the next six months.

The survey is taken every week, but in order to smooth out aberrations, let's focus on the eight-week rolling average. The long-term average is for 39% of investors to be bullish on the market. We'll say that investors are being fearful when that average is one standard deviation below the norm, and say that they're greedy when it's one standard deviation above the norm.

If, starting in 1988 and ending in 2012, the market timer were to only buy stocks when investors became "fearful," and sell them when they became "greedy," here's what the past 24 years of the S&P 500 (INDEX: ^GSPC) would look like.

In the end, taking this approach would have yielded 415%, versus the market's return of 409%. Indeed, following the quasi-Buffett method of buying into the market at certain times slightly outperformed the market.

Are we missing something?Remember, Buffett said the average investor underperformed because of both expenses and a start-and-stop approach.

Even if we give the market timer the benefit of the doubt on expenses and taxes -- they have zero commissions and all of their holdings are in a tax-advantaged Roth account (even though they didn't exist back in 1987) -- we are forgetting about one key thing: dividends. Every time the market timer sells and sits on his money, he is missing out on the dividends offered up by companies.

When we factor dividends into the equation, we see that the long-term buy-to-hold investor outperforms the market timer by more than 100 percentage points.

Source: YCharts, AAII.com, author's calculations.

But we're still missing the pointWithout a doubt, for the average investor who has better things to do than spend all day crunching numbers on the computer, buying and holding an index fund is an excellent choice. But if we were to take Buffett's advice one step further, we could really juice our returns.

Buffett has said several times that the key to investing success is buying companies with great economics in their favor at reasonable prices, and holding them for the ultra-long run. How would an approach like that work? Take a look at how the book value of Buffett's Berkshire Hathaway (NYSE: BRK-B) has appreciated over the same time frame we've been investigating.

The takeaways here are three-fold. First, though valuation matters, trying to time the market is simply a waste of time and energy. Second, dividends matter -- the second chart should make that crystal clear. Finally, buying with an eye on fundamentals and a decades-long future can give you a huge advantage over Wall Street traders.

If you're interested in starting to build your retirement portfolio with quality companies, check out our new special free report: "3 Stocks That Will Help You Retire Rich." I'll give you a hint and tell you that Buffett's Berkshire is actually one of these three, but to find out what other two companies we hold in such high esteem, you need to get a copy of the report today. It's absolutely free!

Fool contributor Brian Stoffel crunched so many numbers for this story that his head is aching. He owns shares of Berkshire Hathaway. You can follow him on Twitter, where he goes by TMFStoffel.

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Artificial sweeteners have not been scientifically shown to have any negative health effects on humans.

Let me repeat that, because people do not seem to comprehend this:

Artificial sweeteners have not been scientifically shown to have any negative health effects on humans.

Please not all these sweeteners must be approved by the FDA, and must include warning labels if there are known dangers associated with them. Saccharin USED TO have such a label, until it was discovered the reason saccharin was harmful to rats was unique to rats.

To the hippies reading this, yes, I'm sure the FDA is just in bed with the evil corporations, just like every other country's version of the FDA who've also deemed artificial sweeteners safe for use.

Buffett's career track record is unmatched. I say "career." His time is well past. Yes they also said his time was past during the tech bubble. But now he is 80. His company is massive and investing in newspapers. Newspapers!! For real?? He can figure out their declining business model but not Google, Apple, or Microsoft?

I owned Berkshire for a number of years and made decent money. I sold in 2007 for about the same price the stock trades today, five years later. I'm not saying you can't make money in Berkshire but the days of big gains are over.

Not to detract from the sweetener theme, but I wanted to actually comment on the main point of the article. I've been thinking about the concept you've spelled out here. Initially what you've highlighted struck me as an epiphany - I should quit trying to time stocks!! But then it felt like something wasn't right about it. I finally realized what that was:

I read Buffet's biography years ago and he did exactly what you're suggesting that he's advising against. He bought low and sold high. His biography showed that that's how he made his money. He timed the market. He dived in huge during recessions and down times for a given stock. Then during the peak times, he got nervous and bailed out, making a fortune. There are instances where he always stayed in there. But many times, he sold off at the peak.

Your article made me realize that a lot of people are taking market timing advice from Warren Buffett who is not only is not a market timer, but didn't encourage or believe in it.

If you're going to time the market folks, at least get your advice from someone who knows how to do it. Greedy/Fearful is not the way to do it as we see from Brian's graph; and lay off the artificial sweeteners people. You would be astonished how that stuff can affect you. I've seen it first hand.

You know, I have thought of dividing my portfolio into 3 parts. My main, which follows the investing style here, and the "play" portion which would be smaller, and divided into a timing portfolio, and a day trading portfolio. Then track all 3 over a decade to compare. (A live test as opposed to back testing.)

Whatever works best will grow the most. And if anything runs out, or drops too low, just stop. (Hey, it was the "play" money.)

And since everyone has jumped on the artificial sweetener bandwagon, this is one of the areas I focus on. (Well diet, and exercise.) All the negativity about artificial sweeteners seems to be similar to conspiracy theories. A lot of hype, and little substance.

We always have to be careful of the "I've seen it with my own eyes," type of thinking. Sometimes it is right, but we need to remember that coloration is not causation. If a person starts using an artificial sweetener, and doesn't feel good, then quits, and starts feeling better, it could have easily been an coincidence.

It doesn't help that our memories are very faulty. Unless you are taking meticulous notes, you are relying on you memories. And if you can't tell me what you had for breakfast, lunch, and dinner 3 days ago, you can't relay on your memories to tell you if your experience is real or not.

And it doesn't help that people don't know how powerful the placebo effect is.

Also to say that artificial sweeteners is worse then sugar is a big mistake. Every once in a while, and well timed, (during, and post workout, and I mean real workout,) is not bad. But excess amounts, and and too often can wreak havoc in our systems.

Much of the negatives of the "Western diet" can be traced back to sugar, and easily digestible, or high GI carbohydrates. And yes there is plenty of research backing this up.

I could elaborate, but I have already made too long a post, way off subject.

I've read Snowball as well. I think there's a difference between timing the market and what Buffett did. He will buy and sell based on valuation. Often times, valuation tends to correlate with market swings, but it's NOT the same as "market timing"--it's looking at the fundamentals of the businesses he holds.

Not to be a nit-picker here, but isn't your "forgone dividend income" analysis just a tad bit intellectually dishonest? Given that even short-term cash deposits pay some interest, isn't it a bit naive to assume that the market-timer wouldn't have collected some interest income in lieu of dividends?

Realistically, shouldn't you at least have assumed money market or short-term T-bill rates when the market timer wasn't invested in equities?

While I agree with your broader points in this article, for me it really weakens an argument when an analyst assumes that the alternative to their preferred option is that the investor would be stuffing cash in his mattress.

Great point. I was actually made aware of the same point a few hours after the piece was published. As you said, I don't think it would change the thesis of the article, but it is an important factor that I overlooked.

This June 2012 article from the Yale Journal of Bio Med should help to shed some light on the issue. If you don't want to read the whole article just read the last paragraph and you'll understand why art. sweeteners are bad for you unless, of course, you are somehow invested in the art. sweet. industry in which case they may still be bad for you when you take a ride in a plane next to that obese person drinking their diet coke.

Brian had such an excellent article that has been so derailed by ALL of the sweetner comments!! Cannot wait to read another article by Brian as it gave me valuable investing information! That is why I visit the Motely Fool website on a near daily basis. Not for the off thread comments! We are investors, Fools not moralists or fear mongers!

I think the fact of the matter is that investor just aren't paying the same multiple for BRK as they used to. There's very little Buffett could (or should) do about this. This may be due to worries about Buffett's age or other factors, but the underlying businesses have continued to perform quite well.